Scaling the World

11/20/2011

U.S. Economic Outlook - Recession or Growth?

[This post has been updated as of 1/21/12]

Is the United States headed into a recession or not? There has been quite a
bit of debate on this topic over the last few months. Naturally, the lack of
consensus on this topic is due to conflicting data and indicators. I'm going to
make an attempt to answer this question using some historical information as a
guide.

Summary

Predicting business cycle turning points and recessions in timely fashion is
extraordinarily difficult. The difficulty is compounded by the fact that there
is no
straightforward quantitative measure defining a recession. Currently,
there's a debate in the United States as to whether the U.S. economy is tipping
into recession heading into 2012. Single indicators like GDP, retail sales,
industrial production, nonfarm employment, etc., at face value appear to be in
non-recessionary territory, thereby leading some economists to conclude that the
U.S. has avoided a recession. The
Conference Board's
Index of Leading Economic Indicators (LEI) has also been on a upswing in recent
months, leading the Conference Board to predict that the U.S. economy will
improve, rather than decline, in the future. In contrast, the
Economic Cycle Research
Institute (ECRI) has been vocal in saying that it's slew of short-, medium-
and long-leading indicators are signaling a definite recession in the U.S. Who
is right?

In this post, I examine some historical data and conclude that the ECRI is
most likely correct and that the U.S. is very likely headed into a recession.
Single indicators are generally not good at forecasting recessions and could be
revised substantially in the future (see Section 2 below). The LEI's track
record has been poor overall (Section 3A). ECRI's track record, while not
perfect in its timing, has overall been stellar (Section 3B) and makes me more
confident that their recession call should be taken seriously.

1. Predicting Recessions

Predicting recessions is no easy business. As The Conference Board
observed in
p. 16 of
this report [I've emphasized sections in bolded text throughout this post]:

However, the fact is that peaks (or even troughs, for that matter) cannot
always be recognized until months after they occur, especially during
periods when the data are subject to significant revision. Therefore, a
considerable amount of research has focused on finding a real-time turning
point rule, which provides adequate warnings.

Unfortunately, it is imprudent to forecast a recession using a simple and
inflexible rule. The U.S. economy is continually evolving, and is far too
complex to be summarized by one economic series. Even official recession
dates for the U.S. economy are determined by a committee of prominent
economists that uses a multitude of indicators rather than a simple rule:
“Why not replace all this agonizing over a multiplicity of measures with a
simple formula—say, define a recession as two consecutive quarters of
decline in GNP? Any single measure is sure to encounter special problems
just when they matter the most.... We plan to stick with examining all of
the data we can and making an informed judgment.” (Robert Hall, Chair, NBER
Business Cycle Dating Committee.)

Predicting these turning points is a difficult task even for the best
forecasters.

2. Single Indicators and Recessions

A number of recent data points on the state of the U.S. economy - I'm going to refer to
these loosely as
"single indicators" - have been interpreted as being positive or better than
expected. For example:

Taken individually or considered together, one might therefore be tempted to conclude that the U.S. has avoided a
recession. This would however not be a good conclusion. To see why, let's first
examine why using single indicators to predict recessions is
a bad idea and we'll then address the concept of considering multiple indicators
together as part of a combined index.

(a) The first thing to recognize with many of the above single indicators
is that they are coincident or lagging
indicators of the economy and are not good predictors of future recessions.

For example,
Doug Short at Advisor Perspectives looked at recessions since WWII and
observed that GDP growth in the
quarter corresponding to the starting month of each recession was positive in 6
out of 11 recessions and zero once. As he notes:

The U.S. has had eleven recessions since the earliest quarterly GDP
calculations, which began in 1948. In the month declared by the National
Bureau of Economic Research (NBER) as the beginning of the recession,
quarterly GDP for that month has only been negative four times.

Of course, GDP is not the only single indicator that is not useful for predicting recessions. Mike Shedlock (Mish) at Global Economic Trend Analysis has
also shown that stocks
are
not good leading indicators by themselves - nor is
consumer sentiment or
M2 money supply. This inference can be extended to several other single
indicators.

(b) Secondly, many of the indicators are also subject to revisions -
sometimes substantially - in the future.

Consider real GDP as an example. In a 2010 paper "The
Income- and Expenditure-Side Estimates of U.S. Output Growth", Jeremy K.
Nalewaik of the Board of Governors of the Federal Reserve System examined the
two official measures of GDP - GDP (I) or GDI and GDP (E) or GDP - to figure out
which of these two measures had a better track record of more accurately
representing the business cycle in real-time. The paper is worth reading
in full, but
here are some of my key takeaways from the paper. In comparison to
the usually reported GDP (E), GDP (I):

Tends to better reflect the extent of growth & declines

Is subject to less severe revisions in the future

Correlates better with major real-time indicators

Appears to be a better predictor of next-quarter GDP (E)

Tends to better predict the direction of future GDP (E) revisions

What is most pertinent to this post is the fact that GDP is
subject to quite a bit of revision - sometimes over a
period of
years. For example:

This chart from the Nalewaik paper is helpful to illustrate the situation as
of Feb 2010. The bottom line is that GDP could get revised quite a bit and using
real-time estimates of GDP to predict recessionary conditions in the future is
often not practical or reliable.

UPDATE 11/24: The BEA has published revised estimates for 2011 GDP.
Here is a chart that summarizes the estimates from Oct 2011 and Nov 2011. Note
the downward revision to Q3 2011 GDP and Q2 2011 GDI. Also notice that GDI is
estimated as declining from 1H 2011 to 2H 2011, whereas GDP is estimated
currently as increasing from 1H 2011 to 2H 2011. Just looking at the state of
the economy, it is hard to argue that 2H 2011 has been better than 1H 2011
overall - I would not be surprised if Q2 and Q3 2011 GDP continue to be revised
down in future releases. Further, given that GDI estimates are treading water so
to speak, a recession in late 2011 or early 2012 is in the realm of possibility.
As
@justinwolfers rightly observed: "The untold story of this recession: The
many false signals given by US GDP data which have given false hope, leading
policy mistakes."

UPDATE 1/21/12: Here are a couple of charts that include the
BEA's
Dec 2011 revisions to GDP and GDI. First, GDP:

And here's the GDI:

The issues of revisions is true for many other indicators.

(c) Thirdly, many indicators could be positive or rise sharply in the middle of recessions.

GDP growth was once positive
during the last two recessions (2008 Q2 at 1.3% and 2001 Q2 at 2.7% - per
the BEA). Stocks could also rise sharply, especially early on in the recession,
when it's not clear that the economy has already irrevocably fallen into a
recession. This chart below, that I put together from the St. Louis Federal Reserve
Economic Database (FRED), makes this point visually.

3. Leading Indicators and Recessions

To really get a sense for what is in store in the future, we need to focus on
indices of leading indicators, as opposed to lagging or coincident
indicators. Two of the most commonly cited indices are The Conference Board's
Index of Leading Economic Indicators (LEI) and the Economic Cycle Research
Institute's (ECRI's) collection of leading indicators, one of which is the more
widely reported Weekly Leading Index (WLI).

(A) The Conference Board's Index of Leading Economic Indicators (LEI)

The LEI recently registered a strong positive number, leading some to assume that
a recession is not in the cards. In fact, LEI growth has been positive
through most of this year and the Conference Board is now sounding
positive regarding the prospects for the U.S. economy
in the months ahead:

The Conference Board reported Friday that its index of leading economic
indicators rose 0.9% last month, significantly faster than the revised 0.1%
rise in September and the 0.3% increase in August.

[...]

Economists said the strong October gain in the leading index and other
positive reports recently had at least eased fears that the economy would be
in danger of slipping into a recession.

Conference Board economist Ken Goldstein said that the latest leading
indicators report was pointing "to continued growth this winter, possibly
even gaining a little momentum by spring."

A natural question to ask in evaluating this forecast from The Conference
Board: what is the prior track record of the LEI?

First, the LEI's individual components are
not necessarily all leading indicators. Second, LEI's track record in
predicting recessions has been underwhelming to say the least.
For example, here's a snippet from an
archived WSJ article by Patrick Barta from April 19, 2001 - inside
the 2001 recession:

...the Conference Board in New York reported the latest results for
its Index of Leading Economic Indicators, which is designed to forecast
where the economy is headed in the next three to six months. While the index
fell 0.3% in March to 108.5 -- the second consecutive monthly decline -- the
board said the pace of the decline wasn't deep enough to prompt an economic
contraction. "No recession is on the horizon," the group said.
Defining a
recession involves many factors, but a common rule of thumb is that it
requires two consecutive quarters of decline in gross domestic product, the
value of the nation's output.

[...]

The Conference Board's
index missed the previous two recessions, in 1990-91 and 1981-82, prompting
some economists to refer to it as the "index of misleading indicators."
That
may be too harsh, considering the index accurately called recessions in the
10 years prior to 1981. And the Conference Board revised the way it compiles
the index in 1995 to eliminate a component that was sending false signals.

The Conference Board has also acknowledged in
this report the issue of false positives in their indicators and the
challenge of calling a recession ahead of time. In past decades, recession
signals in their indicators sometimes emerged only well into the start of the
recession. This problem was present in their data
prior and during the Great Recession. As
this Conference Board paper points out:

The three Ds—depth, diffusion, and duration—of a decline in the LEI can
be a useful tool to analyze whether the economy is headed for a recession.5According to this approach, a recession usually follows when the
(annualized) six-month decline in the LEI reaches 4.0–4.5 percent and the
six-month diffusion index falls below 50.0 percent. As of December 2007, the
six-month decline in the LEI had reached 2.3 percent, which was not deep
enough to signal a recession based on the three Ds criteria (Chart 3). At
that time, the fall in the LEI was being dampened primarily by continued
increases in money supply (M2).6 The six-month decline in the LEI
quickened at the beginning of 2008, but it was not until October 2008 that
it reached and exceeded the threshold decline called for in the three Ds
rule (Chart 4).7 Revisions to the LEI in subsequent months were
relatively small (Chart 5), and they did not alter the cyclical outlook as
they unfolded in real time.

If you look at the chart in their paper, you'll notice that this problem was
compounded by the fact that their metric dropped to ~-4.5% in Jan 2008 but
quickly recovered to ~-1.5% by mid-2008, before dropping again, making it even
more difficult for them to make a recession call at that time. All in all, the
historical data on the LEI leads me to infer that it is *not* a good predictor
of recessions.

However, what is quite striking this time is that the LEI is showing
significant growth - and therefore predicting a positive economic trend for the
U.S. in the coming months - at the same time as the other leading indicator,
ECRI's WLI is predicting the exact opposite! In contrast, both the LEI and the
WLI growth rates declined in the early period of the last two recessions.

(B) ECRI's Leading Indices

Unlike the LEI, ECRI appears to have a
better track record of predicting recessions and growth rate cycles. Although
the April 2001 WSJ article (above) claims ECRI only predicted two of the prior
three recessions, ECRI
claims they called all three of the prior recessions in advance.

ECRI's track record is not perfect. For example, as Mike Shedlock
has pointed out (also see
here), while ECRI called the Great Recession before many others
did, they did so definitively only after the recession had started (a
fact that was itself only established many months subsequently, thereby making
ECRI's call a de-facto prediction in real-time). That said, I've been following ECRI for a long time and I've found
that a less-than-perfectly-timed recession call that is still ahead of others is still a pretty
good and valuable call. My view is that their track record on calling slowdowns,
recessions and recoveries in the last 10+ years has been generally stellar.
Currently, ECRI has been pretty vocal since late September 2011 in saying that the US is on
a recession track:

The U.S. recovery wasn’t much to begin with, and now it’s dead.

That is the news from the widely respected Economic Cycle Research Institute
that said the U.S. has already or is about to tip into recession. The
announcement, made public Friday, was met with skepticism by other
economists who are more hopeful the U.S. and the world will skirt recession.

Lakshman Achuthan, co-founder of ECRI, however says the hope is misplaced.
He says the call is based not just on the weekly leading index that is
disseminated to the public, but also on dozens of other ECRI leading indexes
that are available mainly to ECRI’s clients.

Growth in the weekly leading index, released on Fridays, began to decelerate
in April and turned negative in mid-August.

ECRI has tried to explain their recession forecast further:

The WLI, however, is not the only hammer in ECRI’s toolbox, says Achuthan.

To capture the macro-view, ECRI also puts together a long leading and
short-leading index. The long-leading index, which has no exposure to
equities, started falling back in December 2010 and is still falling.

In particular, the ECRI indexes are signaling the 3 “Ps” of a contraction:
the decline has to be “pronounced, pervasive, and persistent.”

Achuthan makes clear that a recession is a “process” in which a negative
loop feed backs on itself: Slowing demand lowers productions which results
in dropping employment and incomes which in turn weaken sales further.

Ominously, Achuthan says policymakers will not be able to stop this
recession.

UPDATE 11/24/11: I missed pointing out that
Doug Short at Advisor Perspectives has two good charts showing the WLI
growth rate vs. U.S. GDP growth -
here and
here.If you look at the first chart, you'll notice that GDP growth has
generally dropped subsequent to negative periods of WLI growth. Short also links
to an
Oct 2011 report (PDF)
by Hoisington Investment Management. Hoisington says:

Negative economic growth will probably be registered in the U.S. during
the fourth quarter of 2011, and in subsequent quarters in 2012. Though
partially caused by monetary and fiscal actions and excessive indebtedness,
this contraction has been further aggravated by three current cyclical
developments: a) declining productivity, b) elevated inventory investment,
and c) contracting real wage income.

Given ECRI's past track record, I am much more inclined to believe they are
right on their call and that The Conference Board is on the wrong track here.
Only time will tell who was correct.